A History of the Federal Reserve, Volume 2 (43 page)

The New York Reserve bank, with Board approval, also made gold loans to countries to meet temporary payments deficits. At times, the Federal Reserve cooperated with the IMF in its stabilization efforts. An example is a $17 million loan to Argentina to help correct a “structural imbalance in Argentina’s foreign trade position” (Board Minutes, December 22, 1958, 4).
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The Board renewed the loan subsequently.

Except for these occasional decisions, the System paid little attention to the international system until 1958. In that year, it began to include balance of payments, the U.S.’s competitive position, and gold losses as part of the FOMC briefing. International concerns were never a reason in these years for taking, or avoiding, policy action. After the London gold market reopened, the staff studied world demand for gold hoards and industrial and artistic uses relative to gold production (Tamagna and Garber, 1954).
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282. The United States’ shares were sold to three U.S. banks. This is the origin of the privately held shares that remained outstanding until the end of the century, when the Bank withdrew them (memo, Szymczak to Board of Governors, BIS-FRB participation, Sproul papers, March 15, 1950). Although the Federal Reserve did not join, Gates McGarrah, chairman of the New York Reserve bank, became the BIS’s first president.

283. One of the ways in which the New York bank worked with the BIS was making shortterm gold loans. The loans were for a maximum of seven days, could not exceed $25 million, and required approval of the New York directors and the Board. New York shared the income with other reserve banks that participated in the loan (Board Minutes, April 28, 1955, 7–11).

284. Governor Mills described the loan as “the kind of transaction undertaken with very little success after World War I by the Bank of England” (Board Minutes, December 22, 1958, 4). This was not the only time the Federal Reserve ignored its rules for gold loans. Often the Board renewed short-term loans. It voted a loan to Brazil in 1959, collateralized by gold, under pressure from the State Department to help an IMF program succeed. The Federal Reserve also bought gold from the IMF, increasing the monetary base. The IMF sold the gold to replenish its dollar balances, after receiving approval for the sale from the Federal Reserve.

285. Before London reopened its market, gold markets functioned in Hong Kong, Tangiers, and elsewhere. None had the volume of trading that London soon developed, and prices often diverged from the official price. The London market had an advantage as a gold mar
ket over New York. In the 1930s, the U.S. Treasury imposed a 0.25 percentage point fee on purchases and sales in the United States. This widened spreads between bid and ask prices relative to London. By the late 1950s, London market volume reached $1 billion a year, but purchases or sales of more than $25 or $50 million in a day were difficult to complete (Coombs, 1976, 47–48).

Criticisms
of
Bretton
Woods

The Federal Reserve showed no evidence of concern, but outsiders soon questioned the long-run viability of the Bretton Woods system. Friedman (1953, 157) argued that the fixed exchange rate system “is ill suited to current economic and political conditions. . . . There is scarcely a facet of international economic policy for which the implicit acceptance of a system of rigid exchange rates does not create serious and unnecessary difficulties.”
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He proposed that floating exchange rates replace fixed rates. At the time, and for many years after, bankers, policy officials, and governments gave his proposal little consideration.
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Near the end of the 1950s, Edward Bernstein and Robert Triffin separately considered the long-run prospects of the Bretton Woods system, the first of many studies that tried to reconcile a fixed exchange rate system with the domestic employment policies of the United States, the growth of world trade, and increasing capital mobility.
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Bernstein (1960) blamed the problem on continued trade discrimination against the United States, particularly by the countries of the European Community (later the European Union), and “large US Government expenditures in Europe and for Europe, despite the complete recovery of Europe’s capacity to produce and export” (ibid., 5). Bernstein saw the main problem arising from U.S. gold losses as the threat to its ability to follow counter-cyclical monetary and fiscal policies.

Bernstein proposed that the U.S. concentrate on restoring balance to its
payments, while helping the development of low-income countries. The “most effective way . . . is to reduce sharply the transfers and expenditures . . . in Europe and on behalf of Europe” (ibid., 6). These adjustments would leave the U.S. in its dominant position in the international economy. At the time, despite its gold losses, the U.S. still held half the world’s monetary gold stock. Bernstein believed that with two reserve currencies, the dollar and the pound, portfolio adjustments would go from one to the other instead of from the reserve currency into gold. In several respects Bernstein’s views were close to the mainstream views of the time. He did not mention floating exchange rates and did not clearly see the incompatibility of the United States’ commitment to full employment, price stability, a fixed exchange rate, currency convertibility, and free capital flows.
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By 1960, U.S. policymakers became aware that policies to achieve the goals of the Employment Act did not necessarily achieve the Bretton Woods goals.

286. Friedman first wrote his essay in 1950. The policy conflicts he noted included rearmament, trade liberalization, avoidance of direct controls, and harmonization of domestic policies.

287. Canada was an exception. The Canadian dollar had a floating exchange rate from 1950 to 1962.

288. Bernstein had been assistant to Secretary Morgenthau during the Bretton Woods negotiations. He had a major role in developing the U.S. proposal, participated in the Bretton Woods meetings, and was the first research director of the IMF. Triffin, a Belgian, was a Yale professor who had a main role in developing the inter-country settlement system in Europe, known as the European Payments Union, prior to convertibility. Bernstein prepared his paper for the Joint Economic Committee of Congress. Triffin testified before the committee at about the same time. Senator Douglas sent Triffin’s testimony to the Federal Reserve and the Treasury and asked for their comments. Douglas described the testimony as “of such outstanding merit and originality as to deserve the most extensive study on the part of responsible officials.” The Board’s staff described Triffin’s proposals as complex. Neither the Board nor the Treasury gave a detailed reply (Board Minute
s, November 3, 1959, 2–4).

Solomon (1982, 27–32) reviewed accomplishments and problems as they appeared at the beginning of the 1960s. The main accomplishments were the restoration of a fixed exchange rate system. Countries held their exchange rates within a 1 percent band (or smaller) on each side of its dollar parity. The dollar had become the principal reserve currency; foreigners held $10 billion in dollar reserves and an equal amount in British pounds. Industrial countries had avoided parity changes, with France and Canada the main exceptions after 1949. The IMF had started to take on the role of international lender to countries with a temporary payments imbalance.

The principal problems that Solomon recognized were (1) the lack of an adjustment process to reconcile payments surpluses and deficits, (2) no means of adjusting to large capital flows, and (3) the “Triffin problem.” The latter concerned the relation of dollar balances to gold. Since the gold stock grew much less than the volume of international trade, U.S. dollars supplied the additional reserves. As the dollar component of inter
national reserves increased, the system lost the ability to convert dollars into gold at a fixed gold price.

289. Senator Paul Douglas urged the Federal Reserve to favor floating exchange rates. He said he met with “very dubious success” (Joint Economic Committee , 1959, Hearings Part 5, 983). This is an overstatement; the proposal met no response. At the same hearing, Charles Kindleberger pointed out the error in Bernstein’s claim that military assistance to Europe caused the gold loss or the payments deficit. Most of the foreign aid to Europe took the form of U.S. exports (ibid., 951). Kindleberger also noted, in passing, that the U.S. had a budget deficit in 1958, and Germany had a large surplus (ibid., 976). Germany could finance the excess of U.S. investment over saving. The hearings also brought out that the creation of the European Common Market lowered tariffs against U.S. exports in France and Italy but raised tariffs in Germany and the Benelux countries. Of course, the Common Market eliminated internal tariffs over time, putting U.S. exports at a relative disadvantage in all six countries (ibid., 997). This encouraged investment by U.S. companies in Europe, increasing the capital outflow.

The
Triffin
critique.
Beginning in 1947, when the System had just started, Robert Triffin warned that the Bretton Woods Agreement had a fundamental flaw: An expanding world economy required increased means of payment or settlement. The supply of new gold was inelastic, so the additions would have to be dollar balances. These balances would, therefore, rise on an inelastic gold base. The general acceptability of dollars, Triffin argued, depended on convertibility into gold. As the stock of dollars rose absolutely and relative to gold, convertibility would go from doubtful to impossible. If the U.S. did not let the stock of dollars increase, trade would grow slowly or not at all. If the U.S. increased the price of gold, it would have to renege on its commitment to convert dollars into gold at the $35 price. Countries would be unwilling to hold dollars, so the system would break down (Triffin, 1947).

Triffin repeated and expanded his argument several times, notably in Triffin (1960, 57). “It seems most unlikely, therefore, that the growth of dollar or sterling balances can provide a lasting solution to the inadequacy of gold production to satisfy prospective requirements for international liquidity in an expanding world economy.”

Reasoning from the 1931–33 experience, Triffin suggested that one possibility was a run first from the pound to the dollar, then from the dollar to gold. The system would collapse. Triffin believed the more likely alternative was a slowdown of the growth of dollar reserves, reopening the threat of deflation, devaluation, or payment restrictions (ibid., 70).

Triffin’s proposed solution called for expanding the IMF into a world monetary authority capable of supplying a new international medium of exchange. The new IMF would make loans and create reserves under some restrictions on the growth of international money. He opposed both the revaluation of gold and floating exchange rates. His four reasons for not changing the gold price were: (1) the initial change would have to be large, double or triple the $35 price, (2) the initial change would have to be repeated as the world economy grew, (3) increases would produce excess liquidity for a time, and (4) the gains would be distributed unequally, benefiting the Soviet Union, South Africa, and countries with large gold stocks (ibid., 81). Triffin’s criticisms of floating exchange rates repeated common arguments: increased speculation would “accelerate and amplify . . . disequilibriating movements without . . . correcting the internal financial policies which lie at the root of the balance of payments deficits” (ibid., 83).
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290. Triffin (1960, 85) recognized, however, the “hard core of validity in the theory of
flexible exchange rates.” It was better to adjust exchange rates than to attempt to hold “unrealistic” rates. The worst solution, he said, was a permanent system of trade and exchange restrictions (ibid., 86).

Triffin’s argument had great influence on subsequent policies. The influence continued even when it became obvious to all that (1) there was no shortage of reserves, (2) inflation, not deflation, had become a major problem, and (3) countries with sustained payments surpluses remained reluctant to revalue exchange rates out of concern for the effect on their exports. Despite the inflation in the U.S. and abroad by the end of the 1960s, policymakers spent much time, attention, and effort to reach agreement on a new reserve asset to supplement gold and little time on providing an adjustment mechanism.

Three main problems with Triffin’s analysis became important. First, he did not appreciate the major political change that had occurred or that the change could not be reconciled with a fixed exchange rate system. Governments and the public disliked inflation, but they disliked recession and unemployment at least as much. Whether it was the memory of the depression or some other reason, governments attempted to achieve high (full) employment. Most accepted inflation, if it remained moderate. Nowhere was this truer than in Britain and the United States, the reserve currency countries.

Second, contrary to Triffin’s analysis, once the U.S. removed the option of converting dollars into gold, countries accumulated massive dollar balances. They preferred accumulating dollars to allowing greater appreciation of their exchange rates. A principal concern was to avoid loss of exports and any temporary increase in unemployment. Inflation abroad adjusted real exchange rates.

Third, Triffin erred in arguing against revaluation of gold (depreciation of the dollar against gold). At most, the increased risk of depreciation would induce a one-time reduction in private dollar balances.
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Tying the price of gold to the growth of trade or to a price index, as suggested by Keynes (1930) and Fisher (1920), would have provided for orderly increases in the value of the gold stock. The expected trend rate of inflation would be reflected in the dollar price of gold and the interest rate on dollar balances.

Triffin’s analysis and persuasive arguments misdirected attention. There was never much chance of g
etting nations to agree on a world central bank, but that was neither a necessary nor a sufficient condition for an efficient
solution. Triffin’s more persuasive point was the need for institutional changes that would provide more international money. He claimed that adjusting the world price level by increasing international money would solve the problem, but adjusting the world price level by changing the gold price would fail. Others adopted this line of reasoning, most importantly in the United States policymaking group.
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291. At the time, there was no way to predict what central banks and governments would do. We now know that collectively they held dollars and added to their holdings to limit appreciation of their currency.